If This Report Is True, The ECB Is Actually Getting Close To Firing Off The Bazooka

There's a story by
Reuters citing the latest edition of German magazine Der
Spiegel, which is reporting that the ECB is considering
setting an explicit top yield threshold for peripheral nation
borrowing costs at its meeting in September.

In other words, ECB chief Mario Draghi would come out and say
something like: "Italy's 2-year borrowing costs shall not be more
than 300 basis points above Germany's 2-year borrowing costs, and
if it rises above that level, the ECB will come in and press it
down via bond purchases."

It would be an incredible game changer for traders to know that
the ECB was sitting there on the bid at a certain level, standing
ready to buy sovereign debt.

That the ECB would eventually do something like this has been
buzzed about for a long time, but speculation really started
heating up in late July, when Mario Draghi came out and said that
high peripheral borrowing costs were impeding the transmission of
monetary policy, and thus came under the purview of the ECB.

He further hinted at something like this at the August meeting,
when he talked about making purchases at the short end of the
yield curve, offering the market a very clear idea that more
action was on the way.

The problem with the ECB committing to keeping a nation's
borrowing costs low (or relatively low) is that it creates a
moral hazard problem. If Italy knows that the ECB will fund it at
X.XX%, Italy's inclination may be to borrow and spend as much as
possible, knowing there will be no ramifications in the market.

Thus for the ECB to come in and take this step, it also needs
countries like Spain and Italy to submit to conditionality (a
request for official aide, outside supervision, hard deficit
targets, and so forth).

That's why the markets last week were so enthused by growing
chatter that Spain would officially request outside help. If
Spain does that, then the ECB can then step in and use its
unlimited might to smite the bond vigilantes.

Of course, there are a bunch of moving parts. What you're reading
here is a report about a report about a report from one German
magazine.

But what's critical is that the right ideas are starting to
filter intl the right places.

A hard yield threshold would be an incredibly powerful tool,
because assuming that the ECB wanted to keep its credibility,
investors would know that the threshold would not be violated.
Unlike previous ECB bond buying (which was expensive and
ineffective) this would be effective and inexpensive, because in
all likelihood the ECB would have to do very little actual
purchasing, having properly set the market's expectations (See
also: The Swiss National Bank's floor for the EUR vs. CHF).